Basel: What Does IRRBB Demand from Supervisors or Bank Boards?

The Basel Committee on Banking Supervision has posted its latest consultative document, this time on the supervision of interest rate risk in the banking book (IRRBB). I gather we should pronounce that acronym “Herb.”

So, what does Herb want from the world? He needs banking supervisors to fix what money creators have created, setting aside for the nonce the fact that they are generally the same set of institutions.

Why Now?

The Basel Committee hasn’t addressed the specific issue of IRRBB for eleven years, and this review is meant ultimately to replace the results of that one, a 2004 statement of Principles. So, why (other than the simple fact of age) did the old statement require replacement, or at least refreshment?

First, because since the global financial crisis and the central banks’ reactions thereto the world has faced an environment of exceptionally low interest rates. This raises the stakes: many institutions will come under stress when that situation inevitably changes and those rates head up.

Second, BCBS worries about arbitrage. Two sorts of arb are at issue: that between the trading book and the banking book; and that among “banking book portfolios … subject to different accounting treatments.”

At any rate, the document offers the banking-supervisory world two scenarios: first, adoption of a uniform global system of calculating minimum capital requirements for IRR; second, quantitative disclosure of IRR in the banking book. The advantages and disadvantages are what one might expect. The first approach is called the “Pillar 1 “approach, after the so-called “pillars” of banking supervision – minimum cap requirements, review processes – market discipline. Its advantage is that it will level the playing field internationally. The second, the “Pillar 2 approach,” will better accommodate “differing market conditions and risk management practices across jurisdictions.”

The Pillar 1 approach is the more sweeping, and apparently the European members of the committee are pressing it. US banking regulators prefer something closer to the present nation-state-based approach, or Pillar 2. The either/or approach of the document is, then, itself a compromise.

A bit more detail

The consultation builds upon work done after the crisis, in particular in an earlier consultative document, “Fundamental Review of the Trading Book,” May 2012. That review found that losses in the regulatory trading books during the GFC sometimes did arise from instruments that had been accounted for as held-for-trading, then transferred to the regulatory banking book. In the banking book these positions were not subject to Pillar 1 minimum cap requirements.

Under the proposed Pillar 1 approach, banks would be required to project most future notional repricing cash flows that arise either from interest rate sensitive assets or from IR sensitive liabilities, and all off balance sheet items. There are, as always, exceptions. But outside of these, everything has to be reported onto 19 predefined time buckets. The shortest time bucket is an overnight loan, the longest one refers to loans for periods of more than twenty years.

Under the Pillar 2 approach, the risk appetite of a bank in regard to IRRBB “should be calibrated in terms of both risk to economic value and risk to earnings. Risk appetite should be expressed through appropriate policy limits and internal controls.”

Board Responsibilities

Again under the Pillar 2 approach, the banks’ boards will be responsible for setting:

Appropriate limits on IRRBB risk taking and ensuring compliance with those limits;

Adequate systems and safeguards for measurement of IRRBB;

Standards for the valuation of IRRBB positions and measurement of their performance;

A comprehensive IRRBB reporting and review process; and

Effective internal controls and management information systems.

Supervisors should “have specialist resources in the area of IRRBB and perform regular assessments of the effectiveness of each bank’s approach to the identification, measurement, monitoring and control of IRRBB.”

Under either Pillar, Herb looks ready to keep both the supervisors and the supervised institutions busy.

In a statement, the American Bankers’ Association opposed both of the scenarios, especially the notion of a global minimum capital requirement. American banks “should not be shoehorned into a global, one-size-fits-all approach that fits no one well and risks disrupting ongoing programs to prepare for higher interest rates.”

The Committee is asking for comments from interested parties by September 11, 2015.